A Survey of the Charitable Donation Deduction: Past, Present and Future
Lawmakers on Capitol Hill have been floating all sorts of ideas these days to fix our ailing economy. Some have been tried before, with limited success. Others have grown increasingly complex and confusing. And a handful are unlikely to make much difference at all.
As we have discussed on this blog before, politicians on both sides of the aisle are considering whether the tax deduction for charitable donations should be limited or even eliminated. With the nation’s financial challenges, they reason, we cannot continue to give tax breaks to the wealthy for charitable giving.
The charitable sector has responded forcefully, pointing out that it is faced with severe challenges of its own: donations are down, while demand for services is up; and financial investments have not fully recovered. Any reduction in the incentive for charitable giving, they say, will have catastrophic consequences.
All of this discussion begs the question: Where did the idea of a charitable tax deduction come from, and how did it become so deeply entrenched in tax policy?
While tax exemptions go at least as far back as ancient Egypt, the modern concept of charity finds its roots in 16th-century England. Concerned that social upheaval was imminent after a series of agricultural crises and a corresponding migration of the poor from rural to urban areas, Queen Elizabeth I helped to shepherd the Charitable Uses Act and the Elizabethan Poor Law, which were designed to promote and encourage philanthropy amongst the country’s aristocracy and burgeoning merchant classes. The measures identified deserving individuals, including widows, orphans, wounded veterans and the disabled. Those able to work were employed, while the “impotent” would be cared for in poorhouses. Idles, drunkards and vagrants were treated as criminals.
In early America, relief for the poor largely followed the English model until the Sixteenth Amendment was ratified in 1913, permitting the federal government to levy an income tax. The Income Tax Act was passed that October, providing a notable exception for any corporation “organized and operated exclusively for religious, charitable, . . . or educational purposes, no part of the net income of which inures to the benefit of any private stockholder or individual,” words familiar to everyone who works with charitable organizations.
In 1917, Congress turned its attention to charitable donors. The War Revenue Act provided that taxpayers could deduct, limited to 15 percent of taxable net income, gifts and contributions to organizations operated exclusively for religious, charitable or educational purposes. This early concept is still a fundamental one: a person shouldn’t be taxed on money they give away to charity.
The deduction has been adjusted frequently over the years. By 1974, the ceiling for donations to most public charities was set at 50 percent of adjusted gross income (AGI), considerably higher than the original ceiling of 15 percent. In the early 1980’s, Congress experimented with allowing “nonitemizers,” persons who take the standard deduction instead of itemized deductions, to deduct charitable donations from gross income “above-the-line.” In 1993, the written substantiation requirements were refined, requiring a written acknowledgement for any gift over $250 and a written disclosure from the charity of a quid pro quo provided in return for a donation of $75 or more.
After nearly 100 years in effect, why has the charitable donation deduction suddenly become controversial?
Imagine three individuals, each of whom writes a check for $100 to the Save the Whales Foundation, a 501(c)(3) organization.
Mrs. Fishtown’s donation truly costs her $100, because there would be no tax consequences if she pocketed the $100. If Mr. Bellevue pocketed the $100, however, he would owe an additional $40 in tax. Effectively, his $100 donation only costs him $60, with the other $40 coming at the expense of the U.S. Treasury. Itemized deductions have a regressive effect on tax rates, conferring a greater benefit on the wealthy than on the poor.
The primary argument for maintaining the status quo is that income that is given away to charity shouldn’t be taxed. Furthermore, the deduction may encourage philanthropy. A survey conducted in 2010 by Indiana University concluded that 66 percent of wealthy donors were likely to give less to charity if the tax deduction were eliminated. Charitable donations may benefit wealthy donors, but they primarily benefit society by reducing income inequality and providing an efficient means for wealth to be transferred from the rich to the poor.
One rationale for allowing tax exemption for charities is that their activities reduce the burdens on government. If the charitable sector did not exist, feeding the hungry and sheltering the homeless would be the responsibility of the government. If the activities of charities reduce the expenditures of the government, it is logical that the government has less need of the corresponding revenue. Critics of the deduction seem to imply that the charities can bear the expense while the government should still collect the revenue.
Finally, the deduction permits donors to direct their resources in ways that reflect their own priorities and values. For example, if Mr. Bellevue wants to save the whales, but Mr. Maplewood wants to feed the hungry, each is able to make an individual choice and direct the funds as he sees fit.
Critics argue that in a constitutional republic the people elect representatives to make decisions for them. If Mr. Bellevue’s candidate runs on a platform to save the whales, and Mr. Maplewood’s candidate runs on a platform to feed the hungry, then the winning candidate has the right to collect the tax revenue and expend it on his promised endeavor. A freely elected government should be empowered to direct the funds, not each individual.
According to a recent report by the Joint Committee on Taxation (JCT)
, over $217 billion was donated to charities by individuals in 2011 and it appears that those deductions disproportionately benefit the wealthy. For example, late last year, the Wall Street Journal reported
that only 13.5 percent of tax returns report AGI over $100,000, yet such returns claim 81 percent of the charitable deduction. Only 3 percent of tax returns report AGI over $200,000, yet such returns claim 55 percent of the charitable deductions.
Critics point out that charitable giving has remained stable at approximately 2 percent of GDP, regardless of changes to the tax incentive. Donors are generous when the economy flourishes, and they cut back during times of uncertainty, without regard to the tax consequences. Additionally, donors have motives for charitable activity apart from the tax consequences: a person who is committed to giving 10 percent of her income to her church or to underwrite a play at the local theater is not likely to change her behavior, even if the deduction is eliminated entirely. Indeed, charitable donations made primarily for tax purposes may be of dubious merit.
Various solutions are being proposed, including the complete elimination of the deduction. The JCT report mentioned above claimed that individuals give to charity partly because they receive a personal benefit or ‘warm glow’ from helping others and that under a comprehensive income tax system, there is no rationale for allowing deduction of these contributions, at least to the extent they provide a personal benefit. Such a position would directly contravene the notion that income given away to charity should not be taxed.
Some proposed limits are designed to make the deduction less beneficial to the wealthy, including a lower AGI limitation, a floor under which charitable donations would not be deductible or a cap on the value of the benefit that would limit the tax benefit of the deduction to 28 percent of its value even if the taxpayer is in a higher bracket.
Other proposed changes are meant to increase the benefit to middle- and lower income taxpayers, including an idea that was tried in the 1980’s: allowing an above-the-line deduction for charitable donations so nonitemizers could receive a tax benefit for charitable giving. Other suggestions include reducing the paperwork and record-keeping for small donations by allowing employees to donate through payroll deductions reported on Form W-2, and allowing donations through April 15 to be deducted on the prior year’s return. One proposal would create a non-refundable tax credit of up to 12 percent of AGI, which would simultaneously limit the benefit to the wealthy and increase the potential benefit to everyone else.
While not limiting the deduction for charitable donations directly, The American Taxpayer Relief Act of 2012 re-instituted the “Pease Limitation,” which raises revenue by limiting some common itemized deductions among high-income taxpayers. Named after Representative Don Pease, a Democrat from Ohio who served eight terms, the limitation was first imposed in the Omnibus Budget Reconciliation Act of 1990. It was phased out as part of the Bush-era tax cuts. As currently implemented, the limitation applies to charitable contributions, mortgage interest, state taxes, property taxes, and miscellaneous deductions. The limitation isn’t applied to medical expense deductions, the investment interest deduction, casualty, theft or gambling loss deductions. Most of these exempted deductions are less common or they are difficult to qualify for, due to high AGI hurdles. For example, qualified medical expenses are only deductible to the extent they exceed 10 percent of an individual’s AGI.
The Pease Limitation affects individual taxpayers with AGI of $250,000 or more, and married taxpayers filing jointly with AGI of $300,000 or more. Once the threshold has been crossed, the affected itemized deductions are reduced by 3 percent of the amount that the taxpayer’s AGI exceeds the threshold, but the taxpayer’s itemized deductions will not be reduced by more than 80 percent.
Returning to the example of Mr. Bellevue, his AGI of $19,000,000 exceeds the threshold by $18,750,000. The limitation on his $100 charitable donation is the lesser of $562,500 (3 percent of 18,750,000) or $80 (80 percent of 100). Since his charitable donation is limited by $80, he can only deduct $20. At a federal income tax rate of approximately 40 percent, his $100 donation now reduces his tax burden by only $8, a $32 tax increase over the $40 in tax savings he would have enjoyed without the limitation. This violates the fundamental principle that income given away to charity should not be taxed, because income tax is being imposed on $80 of the $100 charitable donation. Note that Mr. Maplewood and Mrs. Fishtown have not been affected.
Besides reviving the Pease Limitation, The American Taxpayer Relief Act also raised the top marginal rate from 35 percent to 39.6 percent. Some analysts have concluded that this increased incentive for charitable giving will offset the Pease Limitation. So what effect might it have on Mr. Bellevue?
In 2012, Mr. Bellevue’s marginal tax rate was 35 percent, so his $100 donation cost him $65. Mr. Bellevue is content to see his personal fortune reduced by $65 each year, knowing that he is preserving the whales for the enjoyment of future generations. In 2013, Mr. Bellevue’s marginal tax rate is 39.6 percent, so he anticipates that the donation will cost him about $60. However, because of the Pease Limitation, the donation actually costs him $92. Mr. Bellevue is not pleased, because his $100 donation has cost him $27 more in 2013 than it did in 2012. Although very fond of whales, Mr. Bellevue decides that a $65 sacrifice on his part is adequate, and decides he will adjust his donation to the Save the Whales Foundation so that his after tax consequences in 2014 are the same as they were in 2012. As a result, in 2014 he will only write a check for $71. The limitation on his $71 charitable donation will be $57 (80 percent of 71), allowing him to only deduct $14. At a federal income tax rate of 39.6 percent, his $71 donation now reduces his tax burden by $6, so he experiences an after-tax cost of $65.
The above examples assume that Mr. Bellevue’s other itemized deductions do not exceed $703,125. If they do, the limitation on itemized deductions would already be met. Since 3 percent of 18,750,000 is $562,500, and 80 percent of $703,125 is also $562,500, and the limitation is the lower of the two calculations, the limitation will not increase even if the itemized deductions are higher than $703,125. That means Mr. Bellevue’s additional $100 donation to Save the Whales will not be limited. It will cost him $60 after taxes in 2013, even lower than the $65 it cost him in 2012.
The charitable donation deduction encourages an otherwise selfless act. Most other deductions generally reward spending that benefits the taxpayer (mortgage interest, property taxes, medical expenses, miscellaneous expenses) or offset other payments that the taxpayer must make, e.g. state taxes. Congress has been promising–some might say threatening–a major overhaul of the tax code for some time. If nothing else, the debate surrounding the charitable donation deduction and the re-institution of the Pease Limitation indicate a willingness on the part of lawmakers to diminish the tax benefits of charitable giving. Congress and the President now seem willing to consider whether a simpler tax system with transparent progressive rates should at least consider eliminating deductions of all kinds, even the one for generosity.